Inflation causes the price of goods and services in an economy to increase over time. We measured it as the rate of change in a period. For example, if a product that cost $100 last year now costs $103, the annual inflation rate would be 3%.
As prices increase due to inflation, the purchasing power of a currency (such as the Australian dollar) decreases. This means you’ll need more funds to purchase the same goods or services.
Inflation doesn’t impact all goods and services the same way and it can be influenced by several factors. Let’s examine how economists measure inflation, what causes it, and its impact on investors.
How do we measure inflation?
Economists typically measure inflation broadly to indicate an economy’s overall increase in prices or the increased cost of living in a country.
It can be measured more narrowly in reference to specific goods or services. Inflation rates may differ across products and services, such as groceries, petrol, clothing, or transport. Inflation measures the price change over the relevant period, whatever the underlying product or service.
The Consumer Price Index (CPI) is Australia’s most well-known measure of inflation. It measures the percentage change in the price of a basket of household goods and services.
If a particular good or service experiences a significant price change (up or down), this can impact the overall inflation rate. For example, if the petrol price increases by 20%, this can increase the overall inflation rate because petrol is a widely-used good.
Generally, we can expect a moderate single-digit inflation rate when the economy is healthy.
The Reserve Bank of Australia (RBA) targets an inflation rate of 2% to 3% based on the CPI. When inflation moves outside this bracket, the RBA may use monetary policy (like increasing or decreasing interest rates) to try to push inflation back within the range. Monetary policy impacts the money supply, which in turn impacts prices.
Who reports the figures?
The Australian Bureau of Statistics (ABS) reports the CPI rate every quarter. It reports the quarterly change and calculates an annual rate for the preceding 12 months.
Inflation was 6.1% in Australia over the 12 months to June 2022, with rising prices a feature of the global economy.
The ABS measures the CPI by collecting the prices of thousands of items. It then calculates the change in price level for each item and aggregates the data to work out the CPI rate.
What causes inflation?
The demand effect or the supply effect can cause inflation.
The demand effect means an increase of money in the economy lifts the overall demand for products more rapidly than production capacity. This leads to price rises caused by demand-pull inflation.
The supply effect sees an increase in prices working their way up through the production process. This is also known as cost-push inflation.
If the cost of raw materials or other inputs increases, this will cause the overall price of goods and services to rise. Increased energy prices, for example, mean a rise in production costs for many consumer goods, resulting in inflationary pressures.
Expectation is another factor that can relate to inflation. People expect consumer price inflation to continue to increase prices, just as workers continue to request pay raises.
This is the price-wage spiral. Rising wages increase disposable income, lifting demand for products and services, which in turn causes prices to rise.
The rise in prices increases demand for higher wages, leading to higher production costs. This puts more pressure on prices, creating a spiralling effect.
Central banks, such as the Federal Reserve in the United States or RBA in Australia, try to avoid high inflation by increasing interest rates. A high official interest rate tends to reduce the money supply and consumer demand, easing inflationary pressures.
How does it impact shares?
Inflation impacts the actual returns that ASX investors receive from shares. If you invest $100 today and make a 5% return, your investment will be worth $105 in a year. But if the inflation rate is 6%, your money will buy you fewer goods than it could a year ago.
Most investors are looking for returns that outpace inflation so they can grow the real value of their investments. The aim is to guard portfolios against the impact of inflation.
Higher inflation rates can put upward pressure on interest rates, as lenders will usually want higher compensation to part with their money. This is because they will be unable to buy the same level of goods with it in the future.
Inflation can also result in central banks tightening credit conditions to slow economic growth and lower pricing pressures.
Higher interest rates can put downward pressure on the value of specific investments. This is especially true for more speculative and higher-growth ASX shares and those with long-term income streams. As inflation and interest rates rise, a higher factor discounts the current value of those income streams.
Why does inflation matter to investors?
In 2022, COVID-19, natural disasters, and geopolitical tensions caused by the Russia-Ukraine conflict have impacted global supply chains, causing actual inflation to rise. ASX shares have also been affected as investors seek higher returns to compensate for the effects of underlying inflation.
Inflation eats up the real value of money, so investors are concerned about the impact on their portfolios. A high inflation rate means investors need to earn a higher rate of return to break even in real terms.
Inflation can also put pressure on share prices. Shares trade on expected future earnings, which are discounted to calculate their current value. As interest rates and inflation rise, so does the discount rate, which tests share price valuations.
Investors may seek to safeguard their portfolios by moving to safe-haven assets such as gold and value shares.
Gold is not a perfect inflation hedge, as it pays no dividends, but it has tended to hold its value over time. Value shares tend to be established businesses with strong current cash flows that are usually expected to grow at a slower pace.
Growth shares, on the other hand, have low cash flows now but are expected to generate significant cash flows in the future. Higher inflation and interest rates are likely to have a more substantial impact on growth shares because their future cash flows are affected more by an increase in the discount rate.
Working alongside inflation
Gently rising inflation is generally seen as a positive for the share market, as it is consistent with the economy growing sustainably. Inflation above a certain level becomes problematic, although the impact differs depending on your investment style.
High inflation comes with higher interest costs, materials and labour costs, and reduced earnings growth expectations. The effects of inflation, however, are one of the key reasons to invest. As cash loses its value over time, you need to invest in some way if you want your money to retain (or grow) its purchasing power.
Investing in ASX shares can produce gains above the inflation rate, allowing investors to make money in real terms. Savings accounts may not keep pace with inflation in a low interest rate environment.
The critical thing is to preserve the value of your money over time. Investing does not have to be complicated — a few ASX exchange-traded funds (ETFs) will do — but by not investing, you run the real risk of inflation eroding your purchasing power.